Inside WCI: State Carbon Budgets

How to hand out allowance money.

This is the second in a short series of posts that explain some important but often overlooked policy issues in the Western Climate Initiative. We’ve written extensively on “allocations“—the method of distributing the carbon permits to the public through auctions or free distribution—but there’s a related issue often confused with allocations. Called “apportionment,” it has important ramifications.

I know, I know, nothing gets the skin tingling like the word “apportionment.” But this is a big question for the Western Climate Initiative—the seven-state-four-province regional cap and trade system. Which states and provinces get to pass out the carbon permits? How many does each get? And who gets the revenue if the permits are auctioned? Ultimately, it’s about the money. Carbon permits have a real cash value, whether they are sold or handed out for free. And we all know that nothing sharpens a negotiation like a pile of money sitting in the middle of the table.

Maybe that’s why WCI has so far produced this masterfully crafted position (pdf):

The Partners are working on an apportionment methodology based on Partner and regional emission reduction goals and requirements. The apportionment methodology will address factors such as production and consumption of electricity, projected population growth and economic activity, and other factors. The Partners intend to have a recommended apportionment methodology by Fall 2008. [Section 7]

Say what?

Before I explain what’s going on here, I’ll put my cards on the table: Sightline believes that state apportionment should be based on protecting consumers and working families—in short, it should be based on climate fairness. That means figuring out where the price impacts will occur and awarding state apportionments there so that auction revenue can be used to assist families. One way to do that might be to apportion permits among states and provinces in proportion to their spending on carbon-energy. I’ll come back to this in a monent, but first I should explain that some of the intuitive answers to apportionment are unfair.

At first blush, it might seem pretty straightforward to figure out the apportionment (sometimes called an “allowance budget”).

Why not award permits based on, say, population or GDP? This sounds pretty good if you live in a state like Washington that emits less per person than the other jurisdictions. Washington’s electricity sector is fairly clean because it relies on lots of hydropower. Washington doesn’t need as many carbon permits as other states do, so pricing pollution won’t raise Washington’s electricity prices much. If permits are apportioned in proportion to population or GDP, the Evergreen State would get more permits than it needs to cover its own emissions. It could sell the extras to businesses in coal-fired states—think: Utah—that need additional permits. So, residents of Utah would be sending checks to Washington. Evergreen staters might be happy, but not the good people of the Beehive state.

But there are worse ways of setting state carbon budgets.

Curiously, one of the worst ways is also one of the most popular, perhaps because it seems straightforward: basing state apportionment on historical emissions.

Why not just distribute the most permits to the places with the highest emissions? Simply, because it rewards energy producers by penalizing energy consumers. Consider this real life example: polluting coal plants in New Mexico generate electricity and sell it to ratepayers in California. Any price increases from cap and trade will be borne by the California consumers. But if New Mexico gets the carbon permits—on the strength of their historic emissions — the value of the permits will accrue to New Mexico. Hence the value of the permits will be unavailable to California to help protect consumers from higher energy prices, a key ingredient in climate fairness. That doesn’t seem right.

I want to say this clearly: a system that awards allowance budgets based on historical emissions will guarantee inequities—and it make genuine climate fairness very difficult.

Take a look at this white paper (pdf) from the Pew Center on Global Climate Change, which reports an interesting economic analysis of the state-level impacts of a hypothetical climate policy. (Pew used a CGE model called ADAGE. While we’ve been critical of CGE models in the past, Pew’s results are still instructive for our purposes here.) On page 27 and in Table A-2, Pew calculates the state winners and losers based on a cap and trade program that used historical emissions to set state allowance budgets.

Big energy-intensive states do very well while cleaner service-economy states do poorly. Wyoming would take in a whopping $1,944 per household while California would net only $188 per household. That’s because the coal and natural gas getting extracted and processed in Wyoming—the source of that state’s big emissions budget—gets consumed elsewhere. So it’s consumers in places like California who would bear the brunt, while the money from the higher prices would be vacuumed into the energy-producing states. That won’t fly.

What’s the right way to handle the apportionment question? Conceptually, the simplest way might be just to avoid apportionment altogether and simply conduct one regional auction with the proceeds going straight to consumers and never touching state or provincial bodies. (Regional “Cap and Dividend.”) But that doesn’t appear to be either legally or politically practical. After all, we’re talking about seven states and four provinces. So we’ll need to figure out some equitable allowance budgeting system.

Here’s an idea. (Full disclosure: this is an idea, one that I think gets the high-level principles right; but it’s not a full analysis or detailed plan.) To design an equitable system we need to understand what different consumers will pay. Who will feel the sharpest pain of any price increases under cap and trade?

We wouldn’t be looking for energy spending exactly, but for carbon-energy spending. This might require some analysis, but I don’t think it would need to be too onerous. It’s pretty easy to figure out how much people in each state spend on transportation fuel and similarly easy for natural gas. Electricity is more perplexing because the supply chains are so tangled, but it should be possible to at least estimate where the carbon-price impacts will occur and where they won’t. Using just these three carbon-energy spending sources—transportation, natural gas, and electricity — should give WCI enough information to proceed.

The allowance budget should map fairly closely to carbon-energy spending. That way auctioned permits can be used to cushion working families or, at minimum, the allowance va
lue can be used for other public goals. For example, a relatively clean state like Oregon wouldn’t experience as much price-pain due to a carbon cap and so it would accordingly receive a smaller share of allowances than would a state like Arizona. While Arizona households would feel more carbon price pain, but they would also benefit from the value of the allowances, which the state could choose to refund to ratepayers or to develop cleaner and more efficient energy systems. Oregon doesn’t need as much allowance-value because the impacts are less pronounced and it doesn’t have as much work to do to de-carbonize itself.

I’ll admit that sometimes people think my proposal sounds counter-intuitive. After all, isn’t the point of carbon pricing to create a signal to avoid pollution? That’s true. But the key is to remember that as long as we have a cap, which does the “work” of reducing emissions, the price signal of carbon still gets communicated. The price signal hits low-income folks too hard, so they need to be compensated, preferably with some form of direct payment. Even if the payments more than cover the cost of higher energy prices—as it should for many folks—the cap is still driving emissions down and sending a carbon price through the economy. Rather than sinking the finances of working households, a smart cap and trade program would provide a gradual and relatively painless path away from carbon-intensive energy.

Anyway, that’s the nutshell. Let me know what you think. I’m curious to refine and improve this idea.

I’ll close by adding that it’s worrisome that WCI hasn’t yet clearly stated a position—not even a draft position—on apportionment yet. The July draft is the penultimate version and it has punted on several important questions, including this one.

Comments

Uncle Vinny

July 29, 2008 at 2:55 pm

It would be fascinating to hear some quick guesses or hypotheticals on what these amounts would be for the provinces and states. Is the total value for the carbon auction for the WCI a known value, for example? Throwing out some example figures would be helpful, even if they were imprecise… but one thing I love about you Sightline people is that you tend to do pretty careful research before hypothesizing!

Mixed apportionment for WCI state carbon budgetsI think your idea of using equity (energy spending) is really good. What I like about it is that it forces us to work through the implications of the fact that carbon pricing affects us all, not just the first point of regulation.On the face of it, though, I don’t see how this proposal could possibly fly, since (to continue your example) giving a large share of New Mexico’s permits to California would force NM’s emitters to buy most of their permits on the open market, which I imagine would be even less politically palatable than forcing all the states to participate in a central auction in the first place.But maybe a modified version could. The modification is to think in terms of equity for business as well. Our goal in auctioning is to avoid windfall profits and capture that revenue (in part) so that we can mitigate impacts on consumers. But it’s important to say also that it’s not our goal to inflict pain on businesses. Our primary goal is to send a price signal, and this does not require harming businesses or consumers—it can in fact be done in a way that’s revenue neutral and actually beneficial to the economy.In principle, the idea here is to give businesses enough free permits to avoid harm; but not enough to create a windfall. The rest of the permits should be auctioned and some of the revenue used to aid consumers—not all, bc that will create windfall profits for consumers, too.Obviously, the thorny political question is how do you decide how many free permits is enough? This would just be a horrible ugly mess except for one fortunate fact: the total pie of allowances is much larger than the number that need to be given either to businesses or consumers. (The reason this is true is that there are a lot of GHG reductions (see, eg., the McKinsey study) that are negative cost. See also Goulder/RFF Confronting Adverse Industry Impacts etc …). So we don’t have to get it exactly right.So … collectively, and probably different for different sectors, the WCI would determine a percentage of permits that need to be freely allocated to regulated emitters. And it also determines a percentage needed to be auctioned to compensate consumers (based as you say on carbon-energy spending). If there’s any sanity, it will result in (ignoring sectoral differences) three terms: A + B + C = 100%, where A is free permits, B is consumer permits, and C is the remainder.(I think a key political outcome would be the acknowledgement that A and B—but especially A—are both less than 1!)These ratios are not binding on states, they are used only for apportionment. A and B become the weighting factors applied to regulated emissions and energy spending respectively (C could go along using the combined ratio). States can still allocate their permits as they wish.Two follow-on thoughts:1. I suspect that a smarter version of this plan would have some year to year dynamics built into it.2. In the above, I’ve conflated “regulated emitters” and “businesses in general”. That’s wrong—and it might make more sense to put non-regulated businesses together with consumers, and maybe that’s what you meant in the first place (ie., energy consumers).

well, you said it yourself, but I’m going to point it out anyway – isn’t the point to send a price signal? I’ve bee wrestling with this down in CA, and I just don’t see how we do this ‘fairly’ (not that we shouldn’t try).Let me use your transportation example. Find out how much people spend on transportation fuel, and then what? Provide those who spend more on fuel – usually by necessity – with a larger share of the proceeds, to blanket the impact. Though I don’t disagree with the economics of it, you will *still* in many cases be rewarding decades of bad land use decisions, while shorting those places who have been progressive about land use and transportation of proceed dollars. Where’s the fairness in that?It’s the same with energy conservation. Every time I run through this exercise, I keep coming up against this, maybe I’m missing something?

Phil,Truly excellent remarks here—thanks! I’m working through your ideas and I’ll write something about them later when I’ve got them sorted out.Justus,It’s a fair point, but consider this silly hypothetical. What if I set up a program that to discourage going to the movies? I could raise the price of movie tickets by $5 but then, in the interest of equity, I could give moviegoers back their money back at the end of the year. The money wouldn’t go back in direct proportion to the number of movies you saw, it would just be returned on a per capita basis. This is “Skytrust for Movies.”I don’t see a reward in this system for “bad behavior.” (i.e. seeing movies). There’s a price signal that discourages going to the movies (according to whatever is the price elasticity of demand) and folks can benefit financially from not seeing movies. Each time you decide not to see a movie, you’re effectively pocketing some of the money from the moviegoers. And if you see more than the average number of movies then you’re effectively giving money to your compatriots who are using Netflix or playing scrabble at home or whatever. Okay, so let’s alter this example to set neighborhood movie allowance budgets. Maybe in neighborhood A movie-going is common (10 movies per year per person), but in neighborhood B movie-going is rarer (just 6 movies per year). If we give back money based on neighborhood movie-spending (the equivalent of my carbon-energy spending) then each neighborhood breaks even: it’s total spending on the movie tax is exactly equal to what it gets back as a rebate. But also… If you live in neighborhood B and you see go to movies 6 times (your neighborhood average), you break even—just as you would if you went 10 times in neighborhood A. If you go to one less, you see a net $5 reward just as in B; if you see one more, you see the same financial penalty, $5, as in neighborhood B.I think this is where my idea starts to look inequitable. A non-moviegoer in neighborhood A does better ($50) than a non-moviegoer in neighbhorhood B ($30). And also, if you live in neighborhood B and see 9 movies, you’re out $15 bucks; but if you lived in neighborhood A you’d actually be ahead $5. So what gives? Neighborhood B is already more “virtuous” in the sense that it doesn’t see a lot of movies. Isn’t this a penalty in some sense?Maybe, but I don’t think so. Consider that neighborhood A’s economy is presumably more closely tied up in cinema—more employment, concession sales, and even cultural connection. In neighborhood A there’s nothing else to do on a Saturday night, and it will take a year or so to start up other social events. Maybe in Neighborhood B there are all kinds of great alternatives. So the dislocation of the $5 movie tax is great in Neighborhood A. And further consider that our objective (for this silly example) is to reduce the total amount of movie-going. The financial incentive is greater in Neighborhood A because Neighborhood B is already much closer to “movie-sustainability.” Another way of saying this is that movie-vice in a neighborhood provides a stronger incentive toward movie-virtue among other residents of the same neighborhood in exact proportion to the need for reducing movies. What better way to reduce movie-going in a film-obsessed neighborhood than by having all that money available for people to quit the movies and take up dancing? Does this make sense? Is it just incoherent rambling? Let’s figure it out!

I understand your point. As I said, I agree with the economics of it – that places where the economic burden falls harder should receive more per person compensation. Your point about dislocation is convincing, since it is the basis for system equity in the first place. IF the system was working, the money would be spent, as you say, in search of other activities (like dancing!); so long as people don’t use the money to just keep watching movies…My point (a small one), to use your example, is not about penalizing moviegoing. It’s about penalizing the choices that made movies the only entertainment in town, when other towns were diversifying choices for the public good (read: transportation). It’s not a matter of moral virtue, just recognizing good and sometimes brave political decision-making where it has occurred. I simply see in this echoes of other decision-making processes, where – for example – the State receives federal transportation dollars based on amount of driving, and therefore has no incentive to cut back…

The concept of “carbon spending” would seem to reward use of oil (which is more expensive per unit of carbon emitted than coal or natural gas). Apportionment to consumers based on historic emissions has been proven by the EThree modeling in California to have the most uniform cost impact.Remember that the carbon-intensive utilities are also the high-cost utilities. The low-carbon utilities are those with lots of low-cost hydropower. Coal and natural gas are much more expensive. In California, the Southern California public utilities like Glendale and Pasadena (50% coal, 5% hydro) have rates around $.14/kWh, while the Northern California public utilities like Santa Clara and Sacramento (20% – 50% hydro) have much lower emissions, and also much lower rates around $.10/kWh. The same is true in Washington and Oregon—Seattle, Tacoma, Eugene, and the PUDs that buy from BPA have very low carbon AND very low rates. The utilities that have been denied access to BPA, including Puget Sound Energy and Portland General Electric have higher carbon and much higher rates. Any method OTHER THAN allocation based on historical emissions exacerbates the existing rate disparity. It is important to realize that ANY form of monetization of carbon results in windfall profits to unregulated owners of nuclear, hydro, and natural gas generation, and excess costs to consumers. The alternative, direct regulation of emissions (a cap, but no trade) minimizes the cost to consumers. In California, EThree measured this impact at $700 million/year based on a $30/tonne market clearing price. If the market clears at a more likely level of $100/tonne, that triples to $2 billion in excess costs to consumers.

Stay up to date on the Northwest's most important sustainability issues.

Research Areas

Founded in 1993, Sightline Institute is committed to making the Northwest a global model of sustainability, with strong communities, a green economy, and a healthy environment. We work to promote smart policy ideas and monitor the region's progress towards sustainability.